If you’re trying to decide how to price your product, or wondering how the process of marking-up an item works, read on. You’ll learn about how cost is determined, why some items sell for so much more than their cost, and how you can decide the best price to sell your product for.
It’s sometimes hard to see how items are priced. Sometimes the cost to the final buyer is much more than for the retailer that sold it. Some prices are marked up hundreds, or even thousands, of times more than they cost to the seller. How can an item bought for so little sell for so much? Is it because sellers are greedy, and want as much profit as possible, or is there another reason?
Sometimes greed does indeed influence the price a product sells for, but often, items must be marked up so sellers can make a profit. While some sellers artificially inflate their prices to take advantage of their clients, most successful merchants know that exploiting the people they depend on for their continued existence is a poor way to run a business, and charge only as much as they need to cover their costs and make a modest profit.
Knowing how much to charge for a product can be very easy, or very hard, depending on not only the product, but the market as well. Armed with an understanding of how cost and markup works, you’ll be prepared the next time you need to decide on a price for your offerings.
We all know in order to make a profit, you have to sell your product for more than it cost you to buy or make it. For example, if you sell coffee, you have to pay for the beans you’re brewing. But it takes more than just beans. So the price of each cup of coffee includes not only the cost of the beans, but the water added to make it drinkable, the electricity used to heat the water, the heat keeping your customers from freezing while they wait, and the rent that allows you to do everything under a roof. Each of these represents something you’ve done to add value to the customer’s purchase, though each one also raises the cost of your product.
Seems simple, right? In some cases it can be, but there may be other factors to consider when pricing your products. Take our earlier coffee example; in addition to the beans and water needed, the building to work in and the heat to keep everyone alive, you may also have to pay for marketing or advertising, such as direct-mail advertising, offers, and special deals. You may also have to pay salespeople to bring in new clients, or spend time finding suppliers for your business. All these considerations add to your cost for each cup of coffee, and increase the price you must charge in order to make a profit.
To determine your cost, first add up everything needed to produce one product. If you get six cups of coffee from each pot, and each pot takes twelve ounces of water, you can calculate your cost on raw materials per pot of coffee. Next, Ask yourself how many cups of coffee will you sell (or expect to sell) each month? How much do you expect your average light bill, rent, and other overhead costs to be each month? Divide your estimated number of products sold a month by your total overhead/costs per month.
This will show your actual cost for each cup of coffee, or other product, you sell. If the idea of doing math scares you, relax. It’s not that hard, and you can probably find someone to help you with the tricky parts. Most importantly, getting an accurate idea of your costs makes it much easier to determine a price later on.
What the Market Will Bear
Once you have an idea of your costs and overhead, you can begin deciding how to price your product. But how much markup should you add to your price? Knowing your market is critical for all business operations, but is especially important here. Why? Because sometimes charging a higher price will result in more sales than a lower one, while other times marking up your product too high could result in no sales at all.
Seems strange, doesn’t it? You would think that people would always prefer the lower price to the higher. But most of us have enough experience in shopping to understand that more expensive usually equals better. Better quality, better service, better value for our money. Whether or not a product actually is better doesn’t matter as much as giving the impression that it is.
Knowing what your customers expect to pay for a product, and what the market will bear, is extremely important when pricing your products. Take Apple, for example. Their cost for the iPhone 6 is estimated somewhere between $200-$247, with labor accounting for about $4.50.(Fudzilla) Yet those of you having purchased one know they retail for much higher, around $649-$849, resulting in a nearly 66% markup!
Sure, people could buy cheaper phones from other companies, but Apple’s customers feel they’re receiving their money’s worth. Perhaps it’s the service. Perhaps it’s the design, the look and feel of the product that makes people pay so much for something they could buy elsewhere cheaper. Whatever the reason, people continue to pay large sums for Apple products, despite having less expensive alternatives of the same quality and ability.
When to Markup
So how do you know when to mark-up a product, or increase its price?
Sadly, there is no single answer that works in every situation. That said, there are a number of indicators that will help you decide how to most effectively price your product.
First, look at your demand. If you can barely keep up with orders, and customers can’t get enough of your products, consider raising your prices. Doing so could slow sales, reducing your workload and giving you time to adapt to increased demand. Of course, it could also increase demand, giving your customers the impression that your products are highly desirable, or limited in quantity.
Another reason to raise your prices is when costs increase. The Hershey company was forced to raise their prices on chocolate products about 8% in 2014 due to the rising cost of the cocoa, dairy products, and nuts required to make them (https://www.cbsnews.com/news/why-chocolate-prices-are-set-to-rise/). While this has resulted in decreased sales, it is an unavoidable part of life for every business, and a cost that must be absorbed by consumers if they want to have chocolate bars in the future.
Your customers will probably never like price increases, but communicating with them why such increases are necessary will go a long way toward earning their trust, respect, and future business.
Examples of Extreme Markup on Common Products
Earlier we mentioned some products having seemingly insane levels of markup, but now let’s point out some real-world examples.
The amount Americans spent on bottled water last year, despite it usually being simple tap water in a fancy bottle, was estimated to exceed 15 billion dollars, more than was spent on iPods or movie tickets. For the price of a single bottle of Evian bottled water, you could pay for 1,000 gallons (3,785.4 liters) of tap water [source: Fishman]. Those buying bottled water are, in effect, paying almost nothing for the water, but a great deal for the packaging and marketing that went into it.
Do you ever buy coffee from a shop, like Starbucks? Then you’re probably already aware how much each beverage is marked up. Making coffee at home averages around 25-50 cents per cup, depending on the quality of beans used. If you bought that same cup from a coffee shop, expect to pay $3 or more, the same price that shop may pay for an entire pound of coffee! Of course, businesses like Starbucks have to pay for supplies like beans and milk, packaging like cups, straws, and napkins, and pay the barista that makes those nifty designs in your latte, so their actual profit margin is only around 7%. [source: Batsell].
Ever enjoy a nice wine when dining out? Then you too may be familiar with how much some products are commonly marked up. On average, bottles of wine in restaurants are marked up 300% [source: Bailey]. Here, it’s hard to point to overhead or costs determining the price, and instead seems to be an example of the restaurants charging what the market will bear.
General Rules of Retail and Markup
To better illustrate the difference between cost and selling price, consider the information below.
Retail price = 100%
Wholesale Price = 60% of Retail
Distributor / Jobber Price = 40% of Retail
Manufacturers sells to Wholesaler / Distributor for $4
Wholesaler Distributor sells to Retailer for $6
Retailer sells to end user for $10
It is suggested by industry experts to aim for a manufacturing cost of 1/3 of Distributors price (i.e. 1/3 of $4 or $1.33) Manufacturing cost does not include administration payroll, marketing expenses, profit, etc.
Based on the above formula if your manufacturing cost is $1.50 you would sell to a wholesaler for $4.50 ($1.50 x 3). The wholesaler would sale it to the retailer for $6.75. The Retailer would sell it to the end user for $11.00 – This gives a markup from manufacturing cost to end user of $7.33
To roughly estimate the retail price of any product, take the cost and multiply it by 7.33
Royalties are typically 5% to 10% (7% being the average)
The Price is Right. Finally.
Deciding what price to charge for your products, or how much to mark them up, can be a difficult decision. Get it wrong, and you won’t sell as much as if you had got it right. Understanding you costs, your customers, your competition, and your market will go a long way toward helping you find that perfect price. Nothing is guaranteed in life, but if you apply these principles to the way you price your products, you’ll have a better change of selling your products for a price you and your customers can live with.